Going public with private annuities.

With the recent changes in the "estate freeze" area, taxpayers are looking for new ways to transfer assets and reduce estate taxes. One method that warrants new consideration is the private annuity.

An annuity is an arrangement under which an individual (the annuitant) contracts with someone else (the obligor) to receive payments for a specified period of time (usually the individual's life). In return, the annuitant turns over property (money or some other asset) to the obligor.

While annuities are traditionally the province of insurance companies, there are situations in which private annuities (that is, annuities made between two individuals) make good tax sense.

A private annuity generally is purchased with appreciated property from someone not in the business of selling annuities. Usually, income generated from the transferred property provides the major portion of the funds paid to the annuitant. While such arrangements often are used to transfer assets between family members, they need not be limited to family situations.

INCOME TAX CONSEQUENCES

To person receiving payments. In exchange for the property transferred, the annuitant receives a regular fixed amount (usually determined by reference to the annuitant's age and sex). Each of the payments received is divided into three elements: an ordinary income portion, a capital gains portion and a "return of capital" porting. The return of capital portion is excluded from gross income, while the other portions are taxable as received.

To the person making the annuity payments. The obligor must pay tax on any income generated by the property. In addition, he or she cannot deduct any portion of the payments made to the annuitant.

Note: To ensure favorable tax treatment, the property transferred cannot be secured by an interest in any other property but must simply be backed by the obligor's unsecured promise. If the annuitant retains a security interest in the transferred property, gains has to be immediately recognized.

ADVANTAGES

Estate taxes. The assets exchanged for the annuity will be removed from the annuitant's estate; this may reduce liquidity problemls for the estate or lower the estate's value below the $600,000 threshold for estate tax.

Gift taxes. As long as the property's fair market value at the time of the transfer is the same as the annuity's present value, there are no gift tax consequences to either the annuitant or the obligor.

Availability. A private annuity may be available when commercial annuities are not.

Control. If the private annuity is an intrafamily transaction, control (and any future appreciation) of the transferred property remains within the annuitant's family.

Income stream. The annuitant achieves a fixed income for the remainder of his life.

DISADVANTAGE

Interest deductions. The obligor does not get the benefit of an interest deduction (although this is less of a problem with the phaseout of personal interest deductions).

Basis in the transferred property. Since the obligor must make payments throughout the annuitant's lifetime, the obligor will wind up any paying too much for the property if the annuitant outlives his life expectancy. On the other hand, the annuitant's early death will leave the obligor with a lower basis than if the property had passed through the estate.

Lack of security. Because a private annuity must involve an unsecured promise to make the annuity payments, there is always the risk of obligor insolvency or bankruptcy, leaving the annuitant with no more rights than any other unsecured creditor.

Valuation. There may be difficulties in determining the income tax value of the property transferred, especially if the property is stock in a closely held corporation.

Liquidity. If the annuitant is of advanced age when this transfer is done (and thus has a lower life expectancy), the payments to the annuitant could be large and be a serious economic burden for the obligor.

Internal Revenue Service challenge. If not done as a bona fide arm's-length transaction, the service may characterize this arrangement as a transfer by gift with a retained life estate. This would then cause an amount to be included in the annuitant's estate.

For a discussion of these transactions, see "Planning with Private Annuities for the Nineties," by Frank Watkins, Steven Brown and Medhat Helmi, in the August 1991 issue of The Tax Adviser.

Nicholas J. Fiore, editor The Tax Adviser